Do acquiring firms knowingly pay too much for target firms? Evidence from earnings management in member-firm mergers in Korean business groups

Abstract

In a typical stock-for-stock merger between the firms belonging to the same business group (member-firm mergers), the controlling shareholder’s holdings in the target firm are more than twice those in the acquiring firm. This difference in the controlling owner’s holdings in the acquiring firm and the target firm creates a strong incentive for the controlling owner to knowingly pay more for the target firm than the target firm is actually worth. We find that acquiring firms deflate earnings in order to increase the numbers of shares to be issued to the target firm’s shareholders. Furthermore, the level of earnings deflation is systematically related with the controlling owner’s expected benefits measured in several different ways. We also find that the stock price reaction to member-firm merger announcements is negatively correlated with the pre-issue-period earnings deflation. In addition, the results show that post-merger performance in member-firm mergers is lower than that in independent firm mergers.